How to navigate an uncertain investment environment

Markets have been under pressure for most part of this year. With US shares suffering the sharpest first half drop in more than 50 years as rising interest rates and economic growth fears continued to worry investors.  Government bonds have also failed to provide an element of protection in portfolios, falling 14.82% this year.

Graph 1: Performance of the S&P 500 in the first two quarters of each year

Sources: Morningstar Direct, PSG Multi-Management

This is not the first time markets experienced increased uncertainty and volatility, and will likely not be the last.

The bellwether for global equities, the S&P 500 Index, has seen numerous and notable market pullbacks over the past 40 years. Over the period, the index has experienced seven bear markets (defined as a pullback of 20% or more) - an average of one every seven years. These bear markets have varied in severity, length, and recovery time. The table below gives a solid historical context to the current market environment, reminding us that these tough times are not uncommon in market cycles. A positive note is that even with these seven bear markets (over the 42-year period) the S&P 500 is still up 11.60% per annum.  The return is due to quick recoveries as evidenced by the S&P 500 generating a +109% return from the bottom of the 2008 crisis within 3-years and a +81% return from the COVID bottom in 2020 within one year. 

We believe the following risks are most pressing in the current market environment:

Inflation: Global inflation is placing pressure on consumers, which impacts corporate earnings. Housing is a large part of the inflation basket in the US and is less transitory than others like energy. The US labour market seems relatively tight, with data showing more vacancies than unemployed participants, which continues to push wages higher. In the US, the V/U (*Vacancies/Unemployed) ratio was over 1.8 in the last quarter of 2021, which meant that there were nearly two vacancies for every unemployed worker. Higher than its pre-pandemic levels, and higher than the recent historical norm of about 0.7 since 2000.

Interest rates: The Fed has begun their hiking cycle, with expectations for more to come, pushing rates up by another 105bps to 200 bps by end 2023.

Pricing power: In the short to medium term, equity markets might remain under pressure as earnings and margins are set to disappoint the seemingly unadjusted consensus analyst expectations. More signs are emerging that the US is headed for an economic contraction, and corporate profits typically shrink about 25% during a recession, according to Data Trek Research.

Russian oil and gas: Supply remains highly important for the EU and should this stop completely, it could cause early-stage recession in Germany.

Government debt: Governments have been running bigger than normal balance sheets and as rates increase, this places more pressure on the overall system. 

Active management remains an important part of a well-managed financial plan

It is critical to stay focussed on your investment plan and not get side-tracked by market noise. This noise includes the current tough market backdrop, a state of affairs heightened by the continued uncertainty around multiple factors of inflation, rising rates and the conflict in Ukraine. It is easy to panic and be thrown off by decisions that are led by emotions, making it important to partner with an adviser who has the correct knowledge and experience in how to navigate a turbulent market.

While risks remain, investors should keep in mind that markets have already fallen a fair amount. Even if recessionary fears are realised, selling equities now in the hope to buy them back cheaper at a later date might not be a prudent strategy. It would require an ability to time the bottom of the market in a way that very few investors, be it professional or retail, have historically been able to do. As capital scarcity increases, we believe active management will become more important.

Staying true to one’s long-term investment plan during these harsh periods is where long-term capital is created.

Emotions can have a big impact on investment decisions – with volatility in markets mirroring the angst and pain investors experience in market downturns. While acute at the time, over the long term, these downturns (and the subsequent emotions), is more like a blip on the radar over most investor’s time horizons.

Being able to decouple behavioural anxiety experienced during market selloffs from the logic of its long-term impact on investments is keenly expressed in various research studies. The graph below on the left shows how the market sell-off (on the S&P 500 Index) in 2009 felt at the time. Then, in contrast on the right, how it looked in the grand scheme of things over a 14-year period.

Graph 2: Market sell-off (on the S&P 500 Index) in 2009

Source: SYZ Investment Banking, Morningstar Direct

Perspective is key

Wealth destruction occurs if we allow the emotions that we experience during these drawdowns to take control and allow us to make irrational decisions.  If an investor had sold all his shares during the 2008 crisis or the COVID crash in 2020, the capital loss (opportunity cost of missing out on the recovery) would have been unrecoverable when extrapolated over the long-term nature of the investment.

Historical data also reminds investors to stay invested through market volatility and full cycles

The graph below shows the 50 largest one day returns realised on the S&P 500 over the last 40 years. Notably, 70% of the time (35 of the 50 biggest days) these high returning days in US equity markets took place during bear markets, or right after the bottom of those bear markets. Empirical evidence also finds that missing those big daily moves in equity markets over time can be terminally detrimental to the long-term compounding ability of an investment.

Staying invested

Source: Fidelity Investments

Our data also shows that even without full-blown bear markets, every year markets experience volatility and pull-backs
The graph below indicates the year-to-year performance in calendar year returns and maximum drawdowns of the PSG Wealth Creator FoF. The Creator has an average annual drawdown of 6.70%, but still has an average calendar year return of 11.60% and has only experienced a negative return in one period, 2018. Since the Creator’s inception, looking through the noise of market crashes and annual drawdowns, the solution has returned 334% since inception or 11.90% per annum.

Graph 3: PSG Wealth Creator FoF: Calendar year returns and drawdowns

Source: SYZ Investment Banking, Morningstar Direct

On the whole, historical examples of bear markets, their magnitude, length of time and recovery, have a limited impact on long-term performance and are in-fact a necessary part of the financial market ecosystem. 

While we can rest assured that this will not be the last time markets are challenged as experienced over the past few months, we can be confident that this too shall pass, and markets will recover. We cannot predict the timing and degree of the recovery, but we remain committed to positioning our solutions in a balanced manner that can both navigate stormy seas and benefit from the recovery when the tide turns. Do not keep your head in the sand, be aware of what is dominating current market dynamics, but also remain true to your investment plan and hold the course, staying invested in times like this is when real growth is realised in the long term.